Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

An August 2012 publication from the Urban Institute Center on Nonprofits and Philanthropy, which examined in detail the huge impact that large nonprofit institutions like universities and hospitals can have on the local community, makes the specter of taxation loom even larger.

Are nonprofits not paying their fair share?As the Urban Institute paper notes, large nonprofits that are exempt from taxation present a huge challenge to municipalities. On one hand, they often represent a huge economic opportunity for a city or town, especially in small towns that rely almost exclusively on a college or hospital for their citizens' employment and income.

Yet those benefits don't come free. Having thousands of students can put a huge burden on traditional city services like police and utilities, yet when universities aren't subject to property taxes on the buildings and land they own, other town taxpayers can get left footing the bill.

The issue isn't limited to small towns. Philadelphia has more than 10% of its total property value owned by nonprofits, while a host of other cities, including Boston, New York City, and Denver, weigh in at more than 5%. With so much of their tax bases exempt from property tax, these cities face challenges to stay in healthy financial condition.

Moreover, some argue that nonprofits have an unfair advantage over for-profit businesses providing similar services. For instance, Apollo Group(Nasdaq: APOL), DeVry(NYSE: DV), and other for-profit colleges don't automatically get the same tax exemption that most nonprofit institutions of higher learning enjoy. Similarly, many hospitals are nonprofit, putting for-profit health facility companiesHCA(NYSE: HCA) and Tenet Healthcare(NYSE: THC) at a competitive disadvantage.

Making a preemptive strikeOne solution that is gaining popularity involves getting big nonprofits to pay local taxes voluntarily. With "payments in lieu of tax" or PILOTs, a nonprofit institution negotiates with a municipality to come up with reasonable compensation for the services the local government provides.

One problem with PILOTs is that they tend to involve one-off solutions to a particular problem rather than a comprehensive policy intended to cover nonprofits broadly. But in Massachusetts, where these arrangements are much more common, the city of Boston has had a PILOT program in place for more than 85 years that currently generates about $15 million a year in extra property tax revenue. Although that amount is less than 1% of the city budget, smaller towns like Bristol, R.I., and Lebanon, N.H., get a much larger share of their budgets covered by PILOTs.

Scrapping for cashEven with innovative ideas like PILOTs, the tax-revenue shortfalls that local governments are facing aren't likely to go away anytime soon. Although cities and towns still get substantial support from state governments, the amount of money they receive from federal sources has fallen dramatically over time.

More recently, the bursting of the housing bubble has depressed property values, reducing tax bases considerably and contributing to local governments' revenue woes. Moreover, as governments scramble to try to fight unemployment, the packages they put together for large employers to attract them to build factories or other facilities in their areas often include tax incentives that lead to reductions in property tax revenue for the localities involved. For instance, a proposed Royal Dutch Shell(NYSE: RDS-A) plant could cost one western Pennsylvania town about 7% of its annual budget due to lost property tax revenue. Similar enticements have gotten increasingly competitive given high unemployment levels.

The result has been increased tension about local government finances. As bankruptcy filings in California for Stockton, Mammoth Lakes, and San Bernardino raise fears that they could be just the tip of the iceberg for a broader jump in municipal bankruptcies nationwide, it's clear that cities and towns can't afford to leave any potential vehicle for tax revenue untouched.

Touching the untouchablesIn many areas, it would've been unheard of even to consider taxing charities. But as some of the biggest players in many local economies, tax-exempt nonprofits need to consider whether the benefits they give local townspeople truly outweigh the costs. If not, then voluntarily making payments in lieu of tax may be the best solution for everyone.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
Follow @DanCaplinger